Part III: Foreign Exchange Risk Exposure and Management

1. Part III: Foreign Exchange Risk Exposure and Management • Outline: • I. Foreign Exchange Exposure • Definitions • Types of Exposure • Why Manage Exposure • II. Transaction Exposure • Measuring Transaction Exposure • Managing Transaction Exposure • III. Operating Exposure • Measuring Operating Exposure • Managing Operating Exposure • IV. Accounting Exposure

2. I. Foreign Exchange Exposure • Foreign Exchange Risk Vs Foreign Exchange Exposure • Foreign Exchange Risk: Variability of domestic-currency values of assets, liabilities and operating income owing to unanticipated changes in exchange rates. (measured by variance) • Foreign Exchange Exposure: refers to what is at risk. Potential gain or loss due to unanticipated changes in exchange rates. • Types of Foreign Exchange Exposure: • Transaction Exposure :- Changes in value of outstanding financial contracts (assets and liabilities) due to unexpected changes in exchange rates. • (e.g. U.S. company owes debt in yen-denominated bond. If yen appreciates, dollar value of debt increases, causing loss). • Operating Exposure:- Changes in PV of firm resulting from changes in future cash flows due to unanticipated changes in exchange rates.

3. I. Foreign Exchange Exposure cont’d • Accounting Exposure:- accounting derived changes in equity value resulting from translating foreign currency financial statements into consolidated statements using a single currency • Exhibit 6.1: Conceptual Comparison of Differences among Operating, Transaction, and Translation Foreign Exchange Exposure (p 187)

4. I. Foreign Exchange Exposure cont’d • Reasons for Managing Exposure: • Reducing Loss • Reduce Risk • Does it add value or return? • Reducing business uncertainty • Exhibit 6.2 Impact of Hedging on Expected Cash Flows of the Firm (p 189)

5. Transaction Exposure • Outline • I. Measuring Transaction Exposure • II. Managing Transaction Exposure • A. Use of Contractual Hedging • - Forward Market Hedges • - Money Market Hedges • - Options Market Hedges • B. Use of Other Financing Policies • C. Use of Operating Policies

6. I. Measuring Transaction Exposure • Transaction Exposure: change in value of outstanding financial contracts due to unexpected changes in exchange rates (usually A/R and A/P) • Measures potential gains/losses in settlement of financial obligations. • E.g. Suppose that a U.S company owes debt in Yen-denominated bond. • If Yen unexpectedly appreciates, dollar value of debt increases ==> loss • If Yen depreciates, dollar-value of debt decreases ==> gain • Suppose U.S. Co. invested in Yen denominated bond, • If Yen appreciates, dollar value of bond increases ==> gain • If Yen depreciates, dollar value of bond decreases ==> loss • Exhibit 6.3: The “Life Span” of a Transaction Exposure (p. 191)

7. II. Managing Transaction Exposure • A. Contractual Hedges • Firms may use instruments in Forward, Money, Futures and Options markets to reduce risk • Forward Market Hedge • Money Market Hedge • Options Market Hedge • Exhibit 7-3: Use of Contractual Strategies for Currency Risk in the United Kingdom • Percentage of Survey Respondents That Use: • Forward Contracts 78% • Futures Contracts 15% • Currency Options 51% • Source: David Edelshain, British Corporate Currency Exposure and Foreign Exchange Risk Management. Ph.D. thesis, London School of Business, 1992.

8. II. Managing Transaction Exposure cont’d • Illustration • In March, Electronix, Inc. of Seattle, Washington, sold internet protocol systems to Kompu-Deutsche of Germany for DM2,000,000. Payment is due three months later, in June. Electronix’s cost of Capital is 10%. The following quotes are available: • Spot exchange rate: DM1.6000/$ • Three month forward rate: DM 1.6120/ $ • Three-month (borrowing or investing) interest rate on U.S Dollars: 6% p.a. (or 2.5% /quarter) • Three-month (borrowing or investing) interest rate on DM: 8% (or 2.0%/quarter) • Three-month options from Bank of America • Call Option on DM2,000,000 at exercise price of DM1.6/$ and a 1% premium • Put option on DM 2,000,000 at exercise price of DM 1.6/$ and a 3% premium.

9. II. Managing Transaction Exposure cont’d • Unhedged Position: • March : Do Nothing • June: Receive DM2m; and sell DM2m at Spot • Result: 1. Maximum receipt - unlimited • 2. Minimum receipt - $0.0 • Forward Market Hedge: • Strategy • March: Sell DM2,000,000 forward @ forward rate of DM1.6120/$ • June: Receive DM2,000,000; Deliver DM against forward sale • Result: Receive (DM2m @ DM1.6120/$ = $1,240,695) regardless of spot rate. • Money Market Hedge: • Involves matching the expected foreign currency cash flow with an offsetting cash flow from a loan contract.

10. II. Managing Transaction Exposure cont’d • Strategy • March: BorrowDM; convert proceeds into $ at spot rate • June: Receive DM2,000,000; Repay Loan = DM2,000,000 • How much to Borrow (lend)? • Amount such that Principal + Interest = Foreign Currency Flow • ==> Let x = amount borrowed • (1 + 0.08*90/360) x = DM2,000,000 ==> x = DM1,960,784 • Strategy • March: Borrow DM1,960,784; convert to $ @ spot rate of DM1.600/$ • Receipt = $ 1,225,490 • June: Receive DM2,000,000 • Pay Principal (DM1,960,784) + Interest (DM39216) = DM2,000,000 • Result: PV of Receipt = $1,225,490 regardless of June spot rates.

11. II. Managing Transaction Exposure cont’d • Comparison with Forward Hedge: • - Depends on how we use the proceeds • Use FV (June)Better Hedge • Invested in US Money Market ($ 1,225,490 @6%/year = $1,243,873 Money Market • Invested in company’s operation ($ 1,225,490 @10%/year = $1,256,127 Money Market • ** Break-Even Rate: Proceeds (1 + r) = Forward Proceeds • $ 1,225,490(1 + r) = $ 1,240,695 • r = 0.0124 • If annual rate > (0.0124 X 4 = 0.05), Money Market hedge is better.

12. II. Managing Transaction Exposure cont’d • Options Market Hedge: • Strategy: • March: Buy put option to sell DM2,000,000 • June: Receive DM2,000,000 • If spot price < strike price, then exercise put (i.e. sell at strike price) • If spot price > strike price, then do not exercise put (i.e sell at spot price) • Result: 1. Limited downside risk • 2. Unlimited receipt in the upside • Specifically, put premium = size of contract X spot rate X premium • {DM2,000,000 /(DM1.6/$)}X 3% = $37,500 or $ 0.01875/DM • Strategy: • March: Buy put to sell DM2,000,000 at strike price of DM1.600/$; Pay premium of $37,500 • June: Receive DM2,000,000 • If spot rate < $0.625/DM, then deliver against Put, receiving $1,250,000 • If spot rate > $0.625/DM, then sell at the spot rate • Result: 1. Minimum Receipt: Total Receipt (DM2,000,000 @ DM1.6/$) = $1,250,000 • Less: FV of Put Premium ((1+0.025)X$37,500) = 38,437.5 $1,211,562.5 2. Maximum: unlimited

13. II. Managing Transaction Exposure cont’d • B. Use of other Financing Policies • 1. Matching currency Cash flows • e.g. U.S. firm with continuing export to Germany. Match the cash flow by raising debt capital in Germany • 2. Back to Back Loan (Parallel Loan, Credit Swaps) • - Two firms in different countries arrange to borrow each other’s currencies for a specified period. Each firm borrows in same currency it pays. • e.g. Suppose a U.S. firm has a subsidiary in U.K, and a U.K firm has a subsidiary in U.S.; and that the subsidiaries need cash in their respective countries currencies. • 3. Currency Swaps • C. Use of Operating Policies • 1. Leads and Lags • 2. Currency Clauses: Risk Sharing • 3. Reinvoicing Centers